The inverted yield curve, as it is well-known, indicates a forthcoming recession. I used it last year to suggest that the recession was not in the near horizon. The conventional explanation follows Wicksellian ideas (see this old post). In the Wicksellian story, one can think of the 10 year bond rate as a proxy for the natural rate of interest, and the Fed Funds for the monetary or banking rate. Hence, whenever the short-term rate (Fed Funds) is above the long-term one, it would be reasonable to assume that borrowing short-term is a bad idea, there is not enough borrowing, and investment falls short of savings. Lower investment would be the cause of the recession, and of deflationary forces.Graph below show the difference between the 10-year bond rate and the Fed Funds, which I have
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Graph below show the difference between the 10-year bond rate and the Fed Funds, which I have noted I prefer to the more common 10-2 spread, since the Fed Funds is more clearly a policy variable, dependent on decisions of the FOMC.
First let me explain that you don't need to believe that the inverted yield curve would cause the recession because the monetary rate is above the natural rate of interest. You may very well think that there is nothing special or natural about the long-term rate. Post Keynesians often think in terms of uncertainty, and the role of expectations. Note that the fears of a recession in this case are related to a collapse of investment (this is the view of certain posties, for example, John Harvey here, that provides always reasonable and clear analysis; he claims to be skeptical about the yield curve).
In the Wicksellian story the high short-term rates (in comparison to the natural) discourage investment too. Here the idea of the marginal productivity of capital plays a central role, while posties would suggest that expectations are more important. But the mechanism is the same. Higher interest rates would lead, along an investment curve that is negatively sloped with respect to interest, to lower levels of investment. You could park your money in short-term securities, and avoid investment.*
But there is no reason to take a marginalist or Wicksellian version of the story. While for WIcksell the natural rate is not a policy variable, that might not be the case with the long-term rate (the 10 year government bonds). In fact, both rates can be influenced by the central bank, and the Fed has a history of switching to longer term securities after a crisis. After the 2008 Global Recession, the Fed increased its holdings of long-term government bonds, maintaining a low interest rate for government debt, and also bought significant amounts of Mortgage Based Securities. Buying long-term bonds pushes their price up, and reduces its remuneration. So lower tong-term rates have been a result of policy decision to some extent.
When the Fed decided to reduce its holdings of long-term securities it basically announced that the interest rate on the long-term bonds would go up. But last year the Fed announced that the program would slowdown and eventually end by this summer. So it basically reversed its previous policy stance, at the same time that it was increasing the short-term rate, presumably because the economy was beyond full employment (or the natural rate of unemployment, if you believe in Friedman's Wicksellian story; for the Fed description of its policies go here). And changes in interest rates and in the structure of rates should have significant effects on the balance sheets of agents spending, and affect the level of activity.
However, I wouldn't expect investment to be the key variable affected by higher short-term interest rates. Indebted agents would cut spending immediately if higher interest rates put pressure on their budgets, either because they have to pay higher interest or because they can borrow at less favorable terms. And sure lower consumption would then impact investment. Firms seeing that consumption is not too strong, would curtail investment, following the so-called accelerator. So I can live with the story that an inverted yield curve, because of a significant and fast increase of short-term rates, can lead to a recession.
And that might happen sooner than I think. But I'm still unsure about the reasons for expecting that immediately. Note that trade is more often than not blamed for the coming recession. See, for example, Greg Ip, from the Wall Street Journal, here, suggesting that trade and not the Fed would be the one blamed for the recession in the future. But as I noted before, I would expect the impact of tariffs to be stronger in China than in the US, and to be more on prices than on quantities. So expect more inflation, and some disruption of the production chains, but not a recession. And the government budget deal seems to inject some additional fiscal stimulus. Perhaps not enough, and perhaps other forces would be sufficient to throw the economy into a recession. But I still think the case for an immediate recession is still not a slam dunk. The slow recovery might continue for a while. But certainly things look worse now than when I wrote last year.
* Yes, that is open to the capital debates critique.